What is a tax credit?
Tax credits reduce your tax liability dollar-for-dollar. For instance, if you owe $5,000 in income tax, a $2,000 credit would reduce the tax to $3,000 ($5,000 less $2,000).
What is a qualifying child?
For tax year 2021, a qualifying child is an individual who does not turn 18 before January 1, 2022. This individual must also satisfy the following conditions:
- The individual is the taxpayer’s son, daughter, stepchild, eligible foster child, brother, sister, stepbrother, stepsister, half-brother, half-sister, or a descendant of any of them (for example, a grandchild, niece, or nephew).
- The individual does not provide more than one-half of his or her own support during 2021.
- The individual lives with the taxpayer for more than one-half of tax year 2021. Exceptions may apply.
- The individual is properly claimed as the taxpayer’s dependent.
- The individual does not file a joint return with the individual’s spouse for tax year 2021 or files it only to claim a refund of withheld income tax or estimated tax paid.
- The individual was a U.S. citizen, U.S. national, or U.S. resident alien. For more information on this condition.
For more info, see IRS Publication 501, Dependents, Standard Deduction, and Filing Information. PDF
What is the Advance Child Tax Credit?
Those of you with qualifying children probably receive a child tax credit every year. If you do not, your modified adjusted income might exceed the qualifying threshold.
Well, for tax year 2021, those who qualify can receive early payments from the IRS of 50 percent of the estimated 2021 Child Tax Credit.
For tax year 2021, the Child Tax Credit is increased from $2,000 per qualifying child to:
- $3,600 for children ages 5 and under at the end of 2021; and
- $3,000 for children ages 6 through 17 at the end of 2021.
That means parents will receive $1,800 of advance credit payments for each child age 5 and under ($300 per month). They will receive $1,500 of advance credit payments for each child age 6 through 17 ($250 per month).
Who Qualifies for the Credit?
What is modified AGI?
For purposes of the Child Tax Credit and advance Child Tax Credit payments, your modified adjusted gross income (AGI) is the sum of your wages, capital gains, investment income and other sources of income. You can find this amount on the 2020 IRS Form 1040, line 11, or the 2019 IRS Form 1040, line 8b). Your modified AGI might also include the following amounts:
- Any amount on line 45 or line 50 of the 2020 or 2019 IRS Form 2555, Foreign Earned Income.
- Any amount excluded from gross income because it was received from sources in Puerto Rico or American Samoa.
When will the advanced credit be disbursed?
If the IRS has processed your 2020 tax return or 2019 tax return, these monthly payments will be made starting in July and through December 2021.
Alright, now that we know what the credit is, let’s discuss the pros and cons of receiving advance payments.
Pros
Funds for Debt, Utilities and other Fixed Costs
Are you struggling financially or living paycheck to paycheck?
If so, this credit can help you pay down debt and other immediate expenses. This credit was created with your family in mind. Prioritize your financial needs and use the advanced credit accordingly.
Investment Opportunities
The time value of invested money increases over a period of time. If your family does not need the additional credit for immediate bills and expenses, you can invest the funds and let the compounding interest begin. This credit can also be an initial investment deposit for a 529 Plan, UTMA account or other investment account for your children.
Giving
Do you know someone struggling financially due to external circumstances? Or, how about a nonprofit or Church making a positive impact? For those of you who are altruistic, these advance payments could provide an opportunity for you to make a meaningful difference in your community.
Financial Literacy
Consider using the advance payments as a learning opportunity. You can let your children allocate a portion of the credit to savings, an investment or a charity. Or, how about letting them use the monthly payments as seed funding for their own business. The advance payments can help you teach your children about budgeting, saving, investing, giving and other areas of personal finance.
Cons
Lifestyle Creep
Let’s say your family qualifies for the advanced credit with three children under five years old. That means you will receive $900 per month from July 2021 through December 2021.
With that extra $900 per month, you could take on an extra car payment, home equity loan or other lifestyle expense. The caveat is, that extra income goes away in 2022. You could end up with an additional monthly expense with no income stream to cover.
If you think you could fall victim to lifestyle creep, consider opting out of the credit or finding accountability to keep your financial goals in line.
Tax Liability
Do you claim your children as dependents on your Form W-4?
Are you self-employed with a tax strategy that includes the child tax credit?
If you answered “yes” to either of these, you will want to consider how the advance credit will impact your 2021 tax liability. If you choose to take the advance, you will have less of a credit to offset your tax liability later.
Repayment
Keep in mind that the credit is an advance.
That means, if you receive more than you are supposed to, you might have to pay it back.
The credit is calculated using your 2019 or 2020 return. Families that expect the following lifestyle changes in 2021 might consider opting out of the credit or developing a tax strategy to legally avoid a tax liability –
- A qualifying child who resided with you may change homes during 2021 and reside more than half of the 2021 tax year with a different individual.
- Your income increases in 2021.
- Your filing status changes for 2021.
- Your main home was outside of the United States for more than half of 2021.
The IRS does provide repayment protection for certain individuals. See below to determine if you qualify for this protection.
If you would like to opt out of the advanced credit, you can unenroll here.
In January 2022, the IRS will send you Letter 6419 to provide the total amount of advance Child Tax Credit payments that were disbursed to you during 2021. Keep this letter regarding your advance Child Tax Credit payments with your tax records. You may need to refer to this letter when you file your 2021 tax return during the 2022 tax filing season.
For more information about the Advance Child Tax Credit, check out the IRS FAQ.